This article appeared in a journal published by Elsevier. The attached copy is furnished to the author for internal non-commercial research and

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2 J. of Acc. Ed. 31 (2013) Contents lists available at ScienceDirect J. of Acc. Ed. journal homepage: Teaching and educational notes Federal income tax laws that cause individuals marginal and statutory tax rates to differ Gregory G. Geisler University of Missouri St. Louis, Department of Accounting, College of Business Administration, 487 SSB, 1 University Blvd., St. Louis, MO , United States article info abstract Article history: Available online 16 September 2013 Keywords: Deduction Exclusion U.S. individual federal income tax Marginal tax rate (MTR) Phaseout Retirement contribution Statutory tax rate (STR) Tax credit This article presents a phaseouts table as a tax educational tool. The table compiles and summarizes the phaseouts of and limitations on deductions, credits, exclusions from income, and allowed contributions for individual U.S. federal income taxpayers in Phaseouts can cause individual taxpayers marginal tax rate (MTR) to be higher than their statutory tax rate (STR) (i.e., bracket based on taxable income). For each phaseout, the table includes how the phaseout works, the adjusted gross income (AGI) range for the phaseout, and the related formula to compute MTR, given STR. The table is appropriate for any course that covers either U.S. federal income taxation of individuals or tax planning. (The phaseouts table is updated annually and is available upon request from the author.) The remainder of the article is a teaching resource, explaining how to compute the specific impact on MTR of each of several example phaseouts. Together, the phaseouts table and article enable U.S. tax instructors to assist students in learning about phaseouts in an integrated, comprehensive manner. Ó 2013 Elsevier Ltd. All rights reserved. 1. Introduction Individual U.S. taxpayers whose adjusted gross income (AGI) is high enough to cause a partial phaseout have a marginal tax rate (MTR) that is higher than their statutory tax rate (STR) bracket Tel.: ; fax: address: geisler@umsl.edu /$ - see front matter Ó 2013 Elsevier Ltd. All rights reserved.

3 G.G. Geisler / J. of Acc. Ed. 31 (2013) Table 1 Impact of student loan interest deduction phaseout on marginal tax rate (filing status is single; year is 2013). Additional Income of $1000 Income $60,000 $61,000 $1000 Student loan interest deduction AGI 57,500 58, Standard deduction Personal exemption Taxable income 47,500 48, Tax (from tax rate schedule) $7804 $8096 $292 Relevant Difference (Geisler & Larkins, 2003). 1 Altshuler and Goldin (2009, p. 335) find that in 2009 MTR was greater than STR for 32% of U.S. individual taxpayers. This finding suggests almost one out of three individual taxpayers in 2009 had one or more tax benefits partially phased out. Table 1 contains an illustration of such a taxpayer. Table 1 assumes a single taxpayer pays deductible student loan interest of $2500 in 2013, that the taxpayer takes the standard deduction instead of itemizing deductions, and that AGI before the student loan interest deduction is $60,000 the beginning of the phaseout range. The first column of Table 1 contains these facts and summarizes the taxpayer s income, deductions, and federal income tax. If AGI were any higher, the taxpayer would not receive the full student loan interest deduction. The second column assumes ordinary income is higher by $1000, so the student loan interest deduction is lower because it is reduced by the partial phaseout. Both changes affect the amount of federal income tax. The third column contains the differences between the first two columns. Under the 2013 tax-rate schedule, a single individual with taxable income over $36,250, but not over $87,850, is in the 25% STR bracket. Comparing tax before the additional $1000 of ordinary income to tax after such income, however, shows an increase of $292. Besides the $250 increase in tax liability caused by the additional income of $1000, the other $42 is caused by the phaseout of $167 of student loan interest deduction for this taxpayer. The $292 net tax increase divided by the increase in income of $1000 results in a 29.2% MTR. Altshuler and Goldin (2009, 335) also found that for 2009 millions of U.S. taxpayers had one or more full phaseouts of tax breaks but no partial phaseouts. For such taxpayers, MTR is the same as STR. The National Taxpayer Advocate s (NTA) 2008 Annual Report to Congress states that more than half of all individual tax returns filed each year are affected by [one or more partial or full] phaseout[s]. The report also states, The most serious problem facing taxpayers is the complexity of the tax code. The report notes that phaseouts are one cause of the complexity and recommends the repeal of, or at least the simplification of, phaseouts. Former President George W. Bush s Advisory Panel on Federal Tax Reform (2005) also recommended eliminat[ing] almost all of these phaseouts for the purpose of simplicity. President Barack Obama s Economic Recovery Advisory Board s Report on Tax Reform Options (2010) was not prescriptive, but it consistently criticized the complexity resulting from both so many phaseouts being in the law and all of them having different AGI ranges where the phaseouts occur. A student learning the U.S. federal income tax laws that affect individuals must deal with this complexity. Using the phaseouts table in this article (Table 2) reduces the complexity. The table contains 1 Consistent with a Joint Committee on Taxation report in 1998 on MTRs (discussed later in the article), (effective) marginal tax rate refers to the increase in tax on an increase in income of $1. To ensure that an increase in income of $1 increases tax, we assume that tax is always computed using the federal tax rate schedules, not the tax tables, and that tax can be in cents (i.e., is not rounded to the nearest dollar). Given a taxpayer s filing status, this article refers to the tax rate bracket that the taxpayer s amount of taxable income is inside as the statutory tax rate. For 2013, such rate is either 0%, when there is no taxable income, or 10%, 15%, 25%, 28%, 33%, 35%, or 39.6% the seven percentages in the individual tax rate schedules. If a change in income is from either long-term capital gain or qualified dividend income, the statutory tax rate can be 0%, 15%, or 20%. If the taxpayer is subject to the alternative minimum tax, the statutory tax rate is either 26% or 28%. All of these STRs ignore the 3.8% Medicare tax on net investment income in excess of a threshold amount.

4 Table Phaseouts for individuals that create effective marginal tax rates (MTRs) different from statutory tax rates (STRs). Source: Joint Committee on Taxation (1998) as updated to 2013 law by Gregory G. Geisler. Estimated number of taxpayers in relevant AGI range updated using most recently available SOI Tax Stats-Individual Statistical Tables by Size of Adjusted Gross Income (AGI). Provision (estimated number in relevant AGI range) Low-Income Taxpayers (1) Phasein of earned income credit (7 million (M)) Phaseout of earned income credit (15M) (2) Limited phaseout of dependent care credit (2M) Code Relevant Adjusted Gross Income (AGI) Range by Filing Status (see Notes) How Phaseout Works Effective MTR 32 $0 $6370 a Credit: Earned income (EI) 7.65% No children: Statutory rate 7.65% $0 $9560 a EI 34% One child: Statutory rate 34% $0 $13,430 a EI 40% Two children: Statutory rate 40% 32(b)(3) $0 $13,430 a EI 45% Three or more children: Statutory rate 45% 32 Joint: $13,310 $19,680 Single or Head of Household (HH): $7970 $14,340 $487 [7.65% (EI b $13,310)] No children: Statutory rate % $487 [7.65% (EI b $7970)] Joint: $22,870 $3250 [15.98% (EI b $22,870)] One child: Statutory rate % $43,210 Single or HH: $3250 [15.98% (EI b $17,530)] $17,530 $37,870 Joint: $22,870 $48,378 $5372 [21.06% (EI b $22,870)] Two children: Statutory rate % 32(b)(3) Single or HH: $5372 [21.06% (EI b $17,530)] $17,530 $43,038 Joint: $22,870 $6044 [21.06% (EI b $22,870)] Three or more children: Statutory rate % $51,567 Single or HH: $17,530 $46,227 $6044 [21.06% (EI b $17,530)] 21 $15,000 Statutory tax rateþ1:5%ðassumes maximum creditði:e:;taxpayer0s total qualifying expenses are $3000 for one qualifying personþþ Statutory tax rateþ3%ðassumes maximum credit ði:e:; taxpayer0s total qualifying expenses are $6000 forptwo qualifying personsþþ $43,001 Dependent care credit: $Dep. care expenses [0.35 [0.15 [(AGI 15,000) 30,000]] (round up to whole%. Max. = Min. = 0)] 432 G.G. Geisler / J. of Acc. Ed. 31 (2013)

5 Table 2 (continued) Provision (estimated number in relevant AGI range) Code Relevant Adjusted Gross Income (AGI) Range by Filing Status (see Notes) How Phaseout Works Effective MTR Max. $Dep. care expenses = $3000 if one qualifying person. Max. $Dep. care expenses = $6000 if two or more qualifying persons. Retirement Related (3) Phaseout of elderly or disabled credit (<0.1M) (4) Phaseout of social security (S.S.) benefits exclusion (7M) (5) Phaseout of maximum contribution to IRA eligible for a deduction e (1M) (6) Phaseout of contribution allowed to a Roth IRA (Not available) 22 Single or HH: $7500 maximum of $17,500 Joint: $10,000 max. of $20,000 c 86 Single or HH: $25,000 various d Joint: $32,000 various d Single or HH: $34,000 various d Joint: $44,000 various d 219 Single or HH: $59,000 $69,000 i Varies Statutory rate + 7.5% Taxable S.S. benefits: 50% (Provisional income 25,000) 50% (Provisional income 32,000) Lesser of 50% (S.S.benefits) or $ % (Prov. Inc. 34,000). Maximum = 85% S.S.benefits Lesser of 50% (S.S.benefits) or $ % (Prov. Inc. 44,000). Maximum = 85% S.S.benefits Maximum deductible contribution: $5500 [1 (AGI $59,000) $10,000] Statutory rate (for first tier) 1.5 Statutory rate (for second tier) 1.85 Single or HH: Statutory rate 1.55 (assuming maximum contribution for under age 50 of $5500) f Joint: $95,000 $5500 [1 (AGI $95,000) $20,000] Joint: Statutory rate (assuming maximum contribution for under age 50 of $5500 by $115,000 i, j one spouse) g,h 408A Single or HH: $112,000 $127,000 i Joint: $178,000 $188,000 i Maximum allowable contribution: $5500 [1 (AGI $112,000) $15,000] Single or HH: Statutory rate (assuming taxpayer would have contributed maximum for under age 50 of $5500 if not for phaseout) k,l $5500 [1 (AGI $178,000) $10,000] Joint: Statutory rate 1.55 (assuming one spouse would have contributed maximum for under age 50 of $5500 if not for phaseout) k,m (continued on next page) G.G. Geisler / J. of Acc. Ed. 31 (2013)

6 Table 2 (continued) Provision (estimated number in relevant AGI range) Education Related (7) Phaseout of American opportunity credit (0.5M) (8) Phaseout of lifetime learning credit (0.5M) (9) Phaseout of qualified student loan interest deduction (1M) (10) Phaseout of education savings bonds interest exclusion (Not available) (11) Phaseout of contribution allowed to a Coverdell education savings account (Not available) Code Relevant Adjusted Gross Income (AGI) Range by Filing Status (see Notes) 25A(i) Single or HH: $80,000 $90,000 i Joint: $160,000 $180,000 i 25A Single or HH: $53,000 $63,000 i Joint: $107,000 $127,000 i 221 Single or HH: $60,000 $75,000 i Joint: $125,000 $155,000 i 135 Single or HH: $74,700 $89,700 i Joint: $112,050 $142,050 i 530 Single or HH: $95,000 $110,000 i Joint: $190,000 $220,000 i How Phaseout Works Percentage of credit phased out: (AGI $80,000) $10,000 (AGI $160,000) $20,000 Percentage of credit phased out: (AGI $53,000) $10,000 (AGI $107,000) $20,000 Percentage of interest phased out: (AGI $60,000) $15,000 (AGI $125,000) $30,000 Excludible savings bond interest: $Interest [1 (AGI $74,700) $15,000] Effective MTR Single or HH: Statutory rate + 25% (assuming maximum credit of $2500 if not for phaseout) n Joint: Statutory rate % (assuming max. $2500 credit if not for phaseout) n Single or HH: Statutory rate + 20% (assuming maximum credit of $2000 if not for phaseout) o Joint: Statutory rate + 10% (assuming maximum credit of $2000 if not for phaseout) o Statutory rate (assuming maximum deduction of $2500 if not for phaseout) Statutory rate (assuming maximum deduction of $2500 if not for phaseout) Single or HH: Statutory rate [1 + (exclusion if not for phaseout divided by $15,000)] $Interest [1 (AGI $112,050) $30,000] Joint: Statutory rate [1 + (exclusion if not for phaseout divided by $30,000)] Maximum allowable contribution: $2000 [1 (AGI $95,000) $15,000] Single or HH: Statutory rate (assuming would have contributed maximum of $2000 for one beneficiary if not for phaseout) p $2000 [1 (AGI $190,000) $30,000] Joint: Statutory rate (assuming would have contributed maximum of $2000 for one beneficiary if not for phaseout) p 434 G.G. Geisler / J. of Acc. Ed. 31 (2013)

7 Table 2 (continued) Provision (estimated number in relevant AGI range) Code Relevant Adjusted Gross Income (AGI) Range by Filing Status (see Notes) Middle- and Upper-Income Taxpayers (12) Phaseout of child credit (1M) 24 Single or HH: $75,000 various i (13) Phaseout of allowable rental real estate loss deduction (Not available) Provision (estimated number in relevant AGI range) (14) Phaseout of adoption credit (Not available) (15) 10% floor for medical deductions (11M) (16) 2% floor for miscellaneous deductions (12M) (17) 10% floor for casualty loss deductions (0.1M) (18) Phaseout of mortgage insurance premiums Joint: $110,000 various i How Phaseout Works Child credit phased out: [(AGI 75,000) 1000](round up to whole number) $50 [(AGI 110,000) 1000](round up to whole number) $50 469(i) $100,000 Maximum allowable deduction: $25,000 $150,000 i [1 (AGI $100,000) $50,000] Code Relevant Adjusted Gross Income (AGI) Range by Filing Status How Phaseout Works 23 $194,580 $234,580 i Credit: $Adoption expenses (maximum $12,970) [1 (AGI $194,580) $40,000] 213 Any taxpayer claiming medical deductions 67 Any taxpayer claiming miscellaneous deductions subject to the 2% floor 165 (h)(2) 163(h)(3) (E)(ii) Any taxpayer claiming casualty loss deductions $100,000 $109,001 Effective MTR Statutory rate + 5% Statutory rate 1.5 (assuming maximum deduction of $25,000 if not for phaseout) q Effective MTR Deduction phased out: 10% AGI Statutory rate 1.10 Deduction phased out: 2% AGI Statutory rate 1.02 Deduction phased out: 10% AGI Statutory rate 1.10 Percentage of deduction phased out: 10% [(AGI (round up to next 1000) 100,000) 1000] Credit: Statutory rate (assumes maximum credit of $12,970 if not for phaseout) r Statutory rate [1 + (deduction amount if not for phaseout divided by $10,000)] (continued on next page) G.G. Geisler / J. of Acc. Ed. 31 (2013)

8 Table 2 (continued) Provision (estimated number in relevant AGI range) deduction (0.1M) (19) Phaseout of itemized deductions (2 million (M)) (20) Phaseout of personal and dependent exemption(s) deduction (2M) Code Relevant Adjusted Gross Income (AGI) Range by Filing Status (see Notes) 68 Single: $250,000 various HH: $275,000 various Joint: $300,000 various 151 Single: $250,000 $372,501 HH: $275,000 $397,501 Joint: $300,000 $422,501 How Phaseout Works Effective MTR Deduction phased out: Statutory rate % (AGI $250,000) s 3% (AGI $275,000) s 3% (AGI $300,000) s Percentage of deduction phased out: [(AGI (round up to next $2500) 250,000)/125,000] [(AGI (round up to next $2500) 275,000) / 125,000] [(AGI (round up to next $2500) 300,000) / 125,000] Statutory rate 1 plus for each exemption (e.g., statutory rate if two exemption deductions) Notes: Relevant AGI ranges for Married Filing Separately status are not included in Table 2. If only one relevant AGI range is listed for a row, then such range applies to joint, single, and head of household (HH) filing statuses. a Assumes all income is earned. b Phaseout is based on the greater of earned income or AGI. c Assumes only one spouse qualifies for the credit. If both spouses qualify, the end of the threshold changes from $20,000 to $25,000. d Phaseout is based on provisional income instead of AGI. e Assumes the individual is an employee who is an active participant, which means that the employee is covered by an employer-sponsored qualified retirement plan. If not, there is no phaseout. f If age 50 or older, assume the taxpayer contributed the maximum of $6500 and change 1.55 to g If age 50 or older, assume the taxpayer contributed the maximum of $6500 and change to h Assume both spouses are active participants and contributed maximum to their IRAs given their age. If both are under age 50, change to If neither is under age 50, change to i Instead of AGI, this phaseout range is based on modified AGI as defined in this provision s Code section. j If one spouse is an active participant and the other spouse is not, the relevant AGI phaseout range for the latter is $178,000 $188,000. This changes the effective marginal tax rate (MTR) formula for the latter spouse. Specifically, MTR for the spouse who is not an active participant changes to STR 1.55 if under age 50 and assuming a maximum contribution of $5500 and changes to STR 1.65 if age 50 or older and assuming a maximum contribution of $6500. k As the Joint Committee on Taxation report (1998) states, The provision phasing out the taxpayer s eligibility to contribute to a Roth IRA does not create an effective marginal tax rate on current year income that is in excess of the statutory marginal tax rate, but rather subjects more income to income tax in a subsequent year. The effective MTR formula assumes the 436 G.G. Geisler / J. of Acc. Ed. 31 (2013)

9 individual s current and future tax rates are the same. It is such future tax on the earnings of the disallowed Roth IRA contribution that increases the effective marginal rate of tax for taxpayers subject to the phaseout range. l If the taxpayer is age 50 or older, assume the taxpayer would have contributed the maximum of $6500 and change to m If the taxpayer is age 50 or older, assume the taxpayer would have contributed the maximum of $6500 and change 1.55 to n Qualifying expenses of $4000 or more generates a $2500 credit per qualifying student. The maximum credit could be in multiples of $2500 if a taxpayer has more than one qualifying student with at least $4000 of qualifying postsecondary education expenses. Assuming that there are two qualifying students and that both have sufficient qualifying expenses for the maximum credit, the credit is $5000 ($2500 2) if not for the phaseout. In this case, change 25 50% in MTR formula for filing single or HH and change % in MTR formula for filing jointly. o Qualifying expenses of $10,000 or more generates a $2000 credit, which is the maximum credit allowed per taxpayer. p As the Joint Committee on Taxation report (1998) states, The phaseout does not increase a taxpayer s current year tax liability. Like the phaseout for eligibility to contribute to a Roth IRA, the provision phasing out the taxpayer s eligibility to contribute to an education IRA subjects more income to income tax in [the future]. q MTR formula is overstated because it ignores that the provision allows losses to be deducted in the future. Other things being equal, the sooner in the future that such losses are deducted, the lower the current year s MTR. r The credit amount is based on qualified adoption expenses up to a maximum of $12,970. Credit is maximum amount if a child with special needs is adopted, regardless of the amount of qualified expenses. s Maximum deduction phased out is 80% multiplied by total itemized deductions other than the medical category, investment interest, casualty and theft loss category, and gambling losses. G.G. Geisler / J. of Acc. Ed. 31 (2013)

10 438 G.G. Geisler / J. of Acc. Ed. 31 (2013) the relevant AGI range over which each phaseout occurs and how each phaseout provision works. The provisions in the table are organized by whether they affect low-income or upper-middle-income individuals and how they affect education- or retirement-related tax breaks. The authors of one text state, The individual marginal tax rate can be an elusive number (Jones & Rhoades-Catanach, 2013). Table 2 also contains formulas that determine how much higher a taxpayer s MTR is than the taxpayer s STR when in a phaseout range. Using the formulas properly can determine an individual taxpayer s exact MTR. The formulas show that the following phaseouts can cause an increase in MTR above the taxpayer s STR of at least five percentage points: the earned income credit phaseout, the phaseout of social security benefits exclusion, the phaseout of the deductible contribution to a traditional individual retirement account (IRA), the phaseout of contribution allowed into a Roth IRA, the phaseouts of the two higher education tax credits, and the phaseout of the child credit. The remainder of this article proceeds as follows: Section 2, Phaseouts Table, contains the table summarizing the 20 phaseouts in effect for In Section 3, Operation of the Phaseouts, the provisions are categorized based on their operational design. Section 4, Two Examples of Determining MTR, continues the analysis of Table 1, the illustration of a deduction phaseout, and also contains an illustration with a credit phaseout. Section 5, What Is MTR When Change in Income Is Taxed at the Long-Term Capital Gain Rate? discusses MTR when an income change is not caused by ordinary income but instead is caused by income taxed at lower-than-ordinary rates. Section 6, What Is MTR When the Individual Taxpayer Is Subject to AMT?, explains how to compute MTR if an individual taxpayer is subject to the alternative minimum tax (AMT) and either one of the phaseouts in Table 2 applies or the AMT exemption deduction phaseout applies. While the preceding sections all focus on how to compute MTR, the next few sections, Section 7 ( Types of Phaseouts ), Section 8 ( Effects of Phaseouts on MTR ), and Section 9 ( Lack of Inflation Adjustments and the Increasing Impact of Certain Phaseouts ) discuss how not all phaseouts are smooth, how the phaseouts have very different impacts on MTR, and how, because there are no inflation adjustments, certain phaseouts impact more taxpayers each year. The next few sections, Section 10 ( Tax Planning ), Section 11 ( Implementation Guidance for Instructors ), Section 12 ( Application Problems for Students ), and Section 13 ( Feedback from Students ) deal with how to avoid or reduce the impact of a phaseout, how to bring the phaseouts table into the classroom, application problems about MTR when a taxpayer is inside a phaseout range, and responses by students to poll questions at the end of two recent semesters about the phaseouts table. Section 14 ( Limitations ) and Section 15 ( Concluding Comments ) follow these sections. 2. Phaseouts table In 1998, the U.S. Joint Committee on Taxation (JCT) summarized in a table titled Summary of Provisions Creating Effective Marginal Tax Rates Different from Statutory Marginal Tax Rates the phaseouts then in effect (Joint Committee on Taxation (JCT), 1998). The table listed the phaseout provisions, displayed the relevant AGI range over which each phaseout occurred, and contained formulas to determine MTR, based on the relative change to the taxpayer s STR, for a taxpayer in the relevant AGI range of any provision. 3 Table 2 in this article updates the JCT s table to Table 2 differs in that it contains both more consistent MTR formulas and also more detailed information about the phaseouts in its footnotes; adds organization by categorizing phaseouts into low-income, education-related, 2 Updates to the table for future years will be done on a continuing basis. Those updates are available, upon request, from the author. The table also contains the author s estimates of taxpayers whose AGI places them inside the phasein or phaseout range for 2009, the most recent year SOI data are available. To the author s knowledge, these estimates have not been updated since their original publication in Some phaseouts use the AGI amount. Other phaseouts use an AGI amount after modification by certain items. Generally, if any of such items apply to a taxpayer, modified AGI is higher than AGI. For only a few provisions, it is possible that modified AGI can be lower than AGI. The modifications are the same for the two higher education credits, the contribution to a Coverdell education savings account, the child credit, and the adoption credit provisions 7, 8, 11, 12, and 14, respectively. For all other provisions where the phaseout range is based on modified AGI, the modifications are different for each provision. The required modifications are organized by IRC section in the footnotes to table on page 476 of the National Taxpayer Advocate s 2006 Annual Report to Congress (NTA, 2006).

11 G.G. Geisler / J. of Acc. Ed. 31 (2013) retirement-related, and upper-middle income categories; and adds a new column on how each phaseout works. 4 If a taxpayer receives one of the tax breaks listed in Table 2 but the taxpayer s AGI is in the Relevant AGI range column (also called the phaseout range) for such provision, MTR will be higher than STR for the taxpayer. 5 Reviewing the formulas in the Effective MTR column (also called the MTR formula) of Table 2 indicates that the difference between provisions can vary from causing MTR to be slightly above STR to causing MTR to be 25 percentage points or more above STR. 3. Operation of the phaseouts 3.1. Overview of the 20 phaseouts Many of the 20 tax breaks listed in Table 2 require specific types of expenditures or receipts. Specifically, 14 of the tax breaks in Table 2 require expenditures. Three tax breaks, the elderly or disabled credit (3), the child credit (12), and the personal and dependent exemption(s) deduction (20), do not require any specific expenditure. The other three provisions, the earned income credit (1), the social security benefits exclusion (4), and the education savings bonds interest exclusion (10), require specific receipts. Nine of the 14 expenditures contain ceilings, before considering the phaseout, that limit the maximum amount of the tax break: the limited phaseout of the dependent care credit; the phaseout of deductible contribution to a traditional IRA by an active participant in his or her employer s retirement plan (hereafter, active employee ); the contribution allowed to a Roth IRA; the American opportunity credit; the lifetime learning credit; the student loan interest deduction; the contribution allowed to a Coverdell education savings account; the allowable rental real estate loss deduction; and the adoption credit (Table 2, items 2, 5, 6, 7, 8, 9, 11, 13, and 14, respectively). For these nine tax breaks, the MTR formulas in Table 2 are made tractable by assuming expenditures are enough to result in the maximum deduction, credit, or allowable contribution if not for the taxpayer s AGI being in the phaseout range. The other five expenditures do not have maximum allowable amounts: the three itemizeddeduction categories (15, 16, and 17); the mortgage insurance premiums (18); and the phaseout of (up to 80% of) certain itemized deductions (19) Phaseouts and contributions Provisions 5, 6, and 11 require contributions to accounts. The partial phaseout of the maximum contribution allowed to either a Roth IRA (6) or a Coverdell education savings account (11) reduces the maximum amount that can be contributed. If any of the phased-out amount has already been contributed for the year, it must be removed from the account. Because of this requirement, the MTR formulas for provisions 6 and 11 replace the assumption that the contribution is the maximum with would have contributed maximum if not for the phaseout. The partial phaseout of the maximum contribution to a traditional IRA (5) by an active employee or by the spouse of such individual reduces the maximum amount of contribution that can be deducted. If any of the phased-out amount is contributed, it becomes nondeductible but does not have to be removed from the account. Instead of assuming, as Table 2 does, that the maximum contribution is made to the IRA (5), or the maximum contribution would have been made to the Roth IRA or the Coverdell education savings account (6 and 11, respectively), assume that the contribution that would be made to any of these accounts before considering any phaseout is less than the maximum. If the taxpayer s AGI is in the phaseout range but the contribution is far enough below the maximum, none of the contribution is phased out. To illustrate, assume a partial phaseout of the maximum contribution to a traditional IRA by an active employee applies. Assume the individual contributing to his or her IRA is under 4 The phaseout of rehabilitation tax credit under passive loss rules (section 469(i)(3)(B)) is not included in Table 2 because it applies to a relatively small number of individuals. 5 The earned income credit contains a phasein at very low income levels. This decreases an individual s MTR. This article focuses on the phaseouts in Table 2, all of which increase an individual s MTR.

12 440 G.G. Geisler / J. of Acc. Ed. 31 (2013) age 50 and that the individual s AGI is 30% of the way into the phaseout range. Instead of reducing deductibility of the individual s IRA contribution by 30%, the law reduces the maximum contribution eligible for deduction by 30% from $5500 to $3850. If the individual contributes $3850 or less, the entire contribution is deductible. Now assume the same facts except that the contribution is to a Roth IRA. None of the contribution to the Roth IRA has to be removed because the contribution does not exceed the maximum allowed. Now assume the same facts except that an individual contributes to a Coverdell education savings account. Instead of reducing the allowable contribution by 30%, the law reduces the maximum allowable contribution to one beneficiary s account by 30% from $2000 to $1400. If the individual contributes $1400 or less, the entire contribution is allowed Provisions where phaseout begins and ends at specific amounts For provisions 1, 3, 7, 8, 9, 10 and 14, the otherwise allowable credit or deduction or exclusion from income is reduced pro rata over the phaseout range (i.e., relevant AGI range column of Table 2). Assume a provision operates this way, and assume a taxpayer s relevant AGI for the provision places the taxpayer 30% of the way into the phaseout range. The taxpayer s credit, deduction, or exclusion from income is only 70% of the amount if AGI was not above where the phaseout threshold begins. The earned income credit (1), elderly or disabled credit (3), and education savings bond interest exclusion (10) phaseouts all work this way. The other four provisions also work this way. The other four all depend on expenditures and have ceilings that limit the maximum credit or deduction. They will be illustrated in more detail now. Assume a taxpayer files single, has AGI of $80,000 or less, and has enough higher education expenditures to qualify for the maximum American opportunity tax credit (7) of $2500. A footnote in Table 2 s Relevant AGI range column indicates that provision 7 uses a modified AGI amount, instead of the actual AGI amount, to determine the phaseout. For simplicity, this article hereafter uses AGI as a general term to include the particular AGI amounts as modified by any phaseout provision. The relevant AGI range column in Table 2 for provision 7 shows that the phaseout threshold begins when AGI reaches $80,000 (i.e., at AGI of $80,000 or less, there is no phaseout of this tax credit) and ends (i.e., the tax credit allowed is $0) when AGI reaches $90,000, so this credit s phaseout range is $10,000 wide. Now assume AGI is $83,000, which is $3000 above where the threshold begins. The taxpayer is 30% ($3000 divided by $10,000) of the way into the phaseout range and therefore loses 30% of the otherwise allowable credit of $2500, which means that $1750 (70% of $2500) is the taxpayer s American opportunity tax credit for Note that this phaseout would work the same way if the expenditure leading to the tax break had been less than the maximum. For example, assume the same facts except that the taxpayer qualifies for only a $1000 tax credit before considering the phaseout. After phasing out 30%, $700 in this example is the taxpayer s credit. The lifetime learning credit (8), the student loan interest deduction (9), and the adoption credit (14) are other expenditures whose phaseout works the same way as the American opportunity credit (7) phaseout Provisions in which end of phaseout varies Provisions 15, 16, and 17 (expenditures in the medical, miscellaneous, or casualty loss itemized deduction categories) increase total itemized deductions only to the extent that the total amount for that category exceeds 10%, 2%, or 10% of AGI, respectively. The phaseout is complete (i.e., none of the category s amount increases total itemized deductions) when the deductible amount for a specific category is equal to AGI multiplied by the percentage cutoff for that category. If the deductible amount in any of these three categories does exceed its percentage-of-agi floor, total itemized deductions will decline if AGI increases further. To illustrate, assume a single taxpayer itemizes deductions, has AGI of $41,000, and has medical expenses that qualify as itemized deductions totaling $5525. The amount phased out is $4100 (i.e., 10% $41,000) and total itemized deductions include $1425 from the medical category. If AGI increased by $1000, from $41,000 to $42,000, then another $100 of medical itemized deductions would be phased out and total itemized deductions would include only $1325 from the medical category. The social security benefits exclusion, child credit, and overall itemized deductions (provisions 4, 12, and 19, respectively) phaseouts begin at specific amounts but do not end at the same amounts for all tax-

13 G.G. Geisler / J. of Acc. Ed. 31 (2013) payers. The social security benefits exclusion phaseout ends when 85% of benefits are included in gross income. The end of this phaseout range is various because it is based on the amount of benefits received. The child credit has a stair-step phaseout that is discussed in Section 7, Types of Phaseouts. The end of the phaseout range for the child credit is various because it depends on the number of qualifying children. Specifically, the phaseout range ends in increments of $20,000 higher for each qualifying child after the first one. If filing single or as head of household (HH), the phaseout range ends at AGI of $94,001 if one qualifying child, $114,001 if two qualifying children, $134,001 if three qualifying children, and so on. If married filing jointly, the phaseout range ends at AGI of $129,001 if one qualifying child, $149,001 if two qualifying children, $169,001 if three qualifying children, and so on. The end of the overall itemized deductions phaseout is various because it depends on the amounts of certain deductions. This phaseout occurs at a rate of 3% of the excess of AGI over the beginning of the phaseout range. However, the total phaseout cannot be greater than 80% of total itemized deductions after subtracting the medical category, the investment interest subcategory, the casualty and theft category, and gambling losses. This maximum phaseout affects where the end of the phaseout range is for any particular taxpayer. It is higher the greater the taxpayer s total itemized deductions for the year after the allowable subtractions. 4. Two examples of determining MTR Returning to the example presented in Table 1, as mentioned earlier the taxpayer s STR is 25% yet the $292 tax increase divided by the increase in income of $1000 is a 29.2% MTR due to the partial phaseout of the student loan interest deduction (9). Assume that instead of ordinary income increasing by $1000 in the second column, it increases by $100 or $500 or $5000 or $10,000 or $15,000. The result is again an increase in tax of 29.2%, because such increases are all inside the phaseout range $60,000 $75,000 of AGI. Instead of assuming in the first column that income is $60,000 and that in the second column AGI increases, assume in the first column that income is $75,000 and that in the second column either an above the (AGI) line deduction, other than of student loan interest, or deductible loss of $100 or $500 or $1000 or $5000 or $10,000 or $15,000 occurs. The MTR is again 29.2% (i.e., a decrease in tax of 29.2% of the deduction or deductible loss) because such decreases in AGI are all inside the phaseout range. Using Table 2, the individual s MTR can be determined for all of the scenarios in the previous paragraph without computing tax in the first column and without computing taxable income and tax after the additional income or deduction and comparing the relevant differences before and after the additional income or deduction (i.e., without the last two columns of Table 1). To do so requires knowing STR, knowing that the taxpayer is not in any other phaseout range except for the student loan interest deduction (9), and knowing that the change in AGI is entirely inside the phaseout range. In other words, given these facts, the Effective MTR column in Table 2 provides the following simple formula to determine MTR without all of the work in Table 1: MTR ¼ STR 1:167 ¼ 0:25 1:167 ¼ 29:2% Table 3 contains another illustration, but this time the only partial phaseout is of a tax credit instead of a tax deduction. Assume the taxpayers are married filing jointly with AGI of $160,000 and one dependent child who is a 20-year-old, full-time college sophomore. Two personal exemptions and Table 3 Impact of credit phaseout on marginal tax rate (filing status is joint; year is 2013). Additional Income of $1000 AGI $160,000 $161, Itemized deductions (includes miscellaneous) 25,000 25,000 Personal & dependent exemptions 11,700 11,700 Taxable income 123, , Tax (from tax rate schedule) $22,683 $22,933 $250 American opportunity credit $125 Amount owed (before tax paid in) $20,183 $20,558 $375 Relevant Difference

14 442 G.G. Geisler / J. of Acc. Ed. 31 (2013) one dependent exemption result in an $11,700 deduction (i.e., 3 $3900). Further, assume that total itemized deductions are $25,000 and none of this total is from the medical or miscellaneous or casualty loss categories. The second column again assumes ordinary income is $1000 higher so that the American opportunity credit becomes partially phased out. The amount owed in the second column is compared to the amount owed in the first column and the difference is computed in the third column Under the 2013 tax-rate schedule, a married couple filing jointly with taxable income over $72,500 but not over $146,400 is in the 25% STR bracket. After the additional $1000 of ordinary income in Table 3, tax after credits shows an increase of $375, so MTR is 37.5%. The $375 increase in tax has two components. One is the increased income, and the other is the increased credit phaseout: $250 caused by the additional income of $1000, taxed at 25%; and $125 (percentage of credit phased out is (($161,000 $160,000)/$20,000) which equals 5%) caused by the partial phaseout of the American opportunity credit (of $2500). The three columns in Table 3 are not necessary to determine that MTR is 37.5%. Instead, knowing STR, knowing that the taxpayer is not in any other phaseout range except for the American opportunity credit (7), and knowing the increase in AGI is entirely inside the phaseout range for this credit is enough information. Reviewing the MTR column in Table 2 for provision 7 shows that this phaseout adds 12.5 percentage points to STR as follows 6 : MTR ¼ STR þ 0:125 ¼ 0:25 þ 0:125 ¼ 37:5% Stated differently, increasing ordinary income by up to $20,000, which increases AGI from $160,000 to the end of the phaseout range, $180,000, increases tax by 37.5% (i.e., the MTR). 5. What Is MTR when change in income is taxed at the long-term capital gain rate? If an individual taxpayer s taxable income in 2013 contains qualifying dividend income and/or net long-term capital gain (LTCG) income, one of the following STRs apply to these two amounts: 0%, 15%, and 20%. However, a 3.8% surtax on investment income also applies when married taxpayers file jointly and AGI is above $250,000. The surtax also applies to single and head of household (HH) statuses when AGI is above $200,000. Effectively, the surtax changes the 20% bracket to 23.8%. The surtax changes the 15% bracket to 18.8% to the extent that AGI is above the threshold. It is rare but it also can change the 0% bracket to 3.8% to the extent that AGI is above the threshold. After incorporating the impact of the 3.8% surtax, there are effectively five STRs for qualifying dividend income and/or LTCG income: 0%, 3.8%, 15%, 18.8%, and 23.8%. Assume a change in income is caused by a change in either of these two specific types of income. To calculate MTR if the taxpayer has tax credits in the phaseout range, add the percentage increases from the applicable MTR formulas in Table 2 to the STR of 0%, 3.8%, 15%, 18.8%, or 23.8% (hereafter, STR LTCG ), as appropriate. Given such a scenario, the general MTR formula is the following: MTR ¼ STR LTCG þ Cr Cr is the sum of the percentage increase(s) for the credit phaseout(s) (from Table 2). If there are no credit phaseouts but there is one other provision (i.e., a deduction, exclusion, or reduction in allowable contribution) in a phaseout range, MTR is not simply the applicable MTR formula from Table 2 with STR LTCG substituting for STR. To calculate MTR, first, use the applicable formula from Table 2 with STR being from the tax rate schedule for ordinary taxable income (hereafter, STR ordinary ). Next, subtract the taxpayer s STR ordinary and add the resulting difference to STR LTCG. The MTR formula that results is the following: 6 Assume a taxpayer is in more than one credit phaseout range. To calculate MTR using Table 2, simply add the percentage increases for the partially phased-out credits together with their STR. For example, assume a taxpayer with Head of Household filing status, a 25% STR, and AGI of $85,000 is subject to partial phaseouts of both the American opportunity credit (7) and Child credit (12). The taxpayer s MTR is 55% (i.e., STR of 25% plus 25% for former phaseout plus 5% for latter phaseout). In contrast, when a variety of partial phaseouts that are not all tax credits apply to a taxpayer, combining the formulas from Table 2 is sometimes complex. One reason for the complexity is that when more than one partial phaseout occurs, the effect on MTR of a partial phaseout that is not a tax credit depends on whether such provision changes AGI or is changed by AGI. Properly combining all possible varieties of partial phaseouts to determine MTR using the formulas in Table 2 is beyond the scope of this article.

15 MTR ¼ STR LTCG þ½ðstr ordinary DedÞ STR ordinary Š Ded is the number greater than 1.0 from the MTR formula column in Table 2 for the applicable phaseout of a deduction, exclusion of income, or reduction in allowable contribution. The reason for such computation of MTR is that the change in income changes tax at the lowerthan-ordinary rate (i.e., STR LTCG ), but the change it causes to the deduction, exclusion, or allowable contribution for which the taxpayer is in the phaseout range changes tax at the ordinary rate. To illustrate this using a comparison, assume the only phaseout a taxpayer is subject to is miscellaneous itemized deductions being reduced by the 2% of AGI floor. Assume AGI is below the threshold where the 3.8% surtax on net investment income applies. Finally, assume that AGI changes due to $1000 of additional ordinary income, and that the resulting level of taxable income places the taxpayer in the 25% ordinary tax rate bracket. MTR equals STR ordinary 1.02 (from 16 in Table 2), so MTR for the assumed situation is the following: MTR ¼ STR ordinary 1:02 ¼ð0:25 1:02Þ ¼25:50% Now compare this result to the same facts, except assume that the change in AGI is because the taxpayer recognizes a $1000 long-term capital gain (LTCG). MTR is the following: MTR ¼ STR LTCG þ½ðstr ordinary 1:02Þ STR ordinary Š G.G. Geisler / J. of Acc. Ed. 31 (2013) MTR ¼ 0:15 þ½ð0:25 1:02Þ 0:25Š ¼15:50% The $1000 LTCG increases taxable income by $1020 because the increase in AGI of $1000 reduces itemized deductions by $20. The additional $1000 of taxable income that results from the LTCG increases tax by $150 (i.e., 15%), and the additional $20 of taxable income that results from reduction in itemized deductions increases tax by $5.00 (i.e., 25% of $20). The net change in tax of $155 divided by the change in income of $1000 is consistent with the MTR formula above: 15.50%. 6. What is MTR when the individual taxpayer is subject to AMT? There are two STRs under the alternative minimum tax (AMT): 26% and 28%. Generally, when an individual taxpayer is subject to the AMT, which is when tentative minimum tax is greater than regular income tax, the MTR formulas in Table 2 use one of these two AMT rates as the STR (hereafter, STR AMT ). If a taxpayer is subject to AMT but a provision in Table 2 is not applicable under the AMT, even if the taxpayer s AGI places the taxpayer in that provision s phaseout range under the regular income tax, you should ignore such provision in determining MTR. In 2013, this occurs only for miscellaneous itemized deductions (16). Assume a taxpayer s total itemized deductions include some from the miscellaneous category. Miscellaneous itemized deductions are not allowed under the AMT, so if a taxpayer is subject to AMT the MTR formula for provision 16 in Table 2 does not apply. The phaseout of the AMT exemption deduction is not in Table 2 because it can occur only when AMT is paid. Its phaseout range is based on Alternative Minimum Taxable Income (before the AMT exemption deduction) instead of AGI. Its effect on MTR and its phaseout ranges, by filing status, are in Table 4. Table Phaseout for upper-income individuals that creates effective MTR different from alternative minimum statutory tax rate. Provision (estimated number in relevant AGI range) (1) Phaseout of AMT exemption deduction (2 M) Code Relevant AMT Income Range by Filing Status 55(d)(1); Single or HH: $115,400 $323,000 How Phaseout Works AMT exemption deduction: $51,900 [51,900 [(AMTI $115,400) $207,600] 55(d)(3) Joint: $153,900 $477,100 $80,800 [80,800 [(AMTI $153,900) $323,200] Effective MTR STR AMT 1.25

16 444 G.G. Geisler / J. of Acc. Ed. 31 (2013) The phaseout range column of Table 4 is based on an AMT exemption deduction for 2013 of $51,900 for single and HH filing statuses and $80,800 for joint filers. Using the MTR formula in Table 4 when a taxpayer has part of the AMT exemption deduction phased out, MTR becomes 32.5% (i.e., 26% 1.25) or 35% (i.e., 28% 1.25) when the AMT statutory rate (STR AMT ) is 26% or 28%, respectively. When a taxpayer is subject to AMT and an increase in income is made up of LTCG and/or qualified dividend income taxed at 0%, 3.8%, 15%, 18.8%, or 23.8%, the two MTR formulas in Section 5 apply. Assuming the only phaseouts are of credits, the MTR formula is the same as in Section 5, STR LTCG + Cr. If there is one phaseout and it is not of a credit, substitute STR AMT for STR ordinary so the MTR formula from Section 5 becomes STR LTCG + [(STR AMT Ded) STR AMT ]). Assume a taxpayer subject to AMT is in the phaseout range for the AMT exemption deduction and has an increase in income taxed at the LTCG rate of 15%. If STR AMT is 26% or 28%, the taxpayer s MTR on the LTCG is 21.5% (i.e., 15% + [32.5% 26%]) or 22% (i.e., 15% + [35% 28%]), respectively. The change in income taxed at the LTCG rate changes tax by 15% but also changes the AMT exemption deduction, and such impact is at the regular AMT statutory rates. To illustrate, additional LTCG income of $1000 increases tax by $150 but also reduces the exemption deduction by $250. Multiplying STR AMT of 26% or 28% by a $250 decrease in deductions results in $65 or $70 more tax, respectively. The total change in tax of $215 or $220 divided by the change in income of $1000 is 21.5% or 22%, respectively Types of phaseouts: smooth and stair-step For simplicity, the formulas in Table 2 assume smooth phaseouts, but four provisions contain stair-step phaseouts. One such provision is the partial phaseout of the dependent care credit (2). The credit is reduced by one percentage point for each $2000 (or portion thereof) that AGI exceeds $15,000. Before AGI exceeds this threshold, the credit s rate is 35%. The rate is 20% when AGI exceeds $43,000. Thus, the dependent care credit is only a limited phaseout instead of a complete phaseout. Another such provision is the phaseout of the child credit (12). The credit is phased out in $50 increments for each $1000 (or portion thereof) that AGI exceeds the beginning of the phaseout range. Another such provision is the mortgage insurance premiums deduction (18). This expenditure, which is included in the itemized deduction category of interest, is phased out in 10% increments for each $1000 (or portion thereof) that AGI exceeds the beginning of the phaseout range (i.e., $100,000). Another such provision is the exemption(s) deduction phaseout (20). Once the threshold is reached, 2% of the total exemption amount is phased out for every $2500 (or portion thereof) that AGI increases. To illustrate, assume married taxpayers filing jointly and AGI is in the phaseout range from $300,001 to $302,500. Two percent of the total deduction for exemptions is phased out. For 2013, the amount of each exemption deduction is $3900. Assuming two personal exemption deductions and no dependent exemption deductions, 2% of $7800 is a $156 phaseout. However, moving from $302,500 to $302,501 of AGI causes 4% of the deduction to phase out. This $1 increase in AGI lowers the exemption deduction by an additional 2% of its total before any phaseout. Continuing with the same assumptions, the result is a $312 phaseout. 8. Effects of phaseouts on MTR: some are minor and some are major The ordinary STR schedule has seven rate brackets: 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. The smallest of the six jumps between the seven rate brackets, from 33 to 35%, is two percentage points. Three common phaseouts specifically, of miscellaneous itemized deductions (16), of total itemized deductions (19), and of the exemption(s) deduction (20) cause MTR to be only slightly higher than STR because their MTR formulas are STR, which is a maximum of 0.396, multiplied by a number only 7 Combining the AMT exemption deduction phaseout along with all possible varieties of partial phaseouts properly to determine MTR when the taxpayer is subject to AMT is beyond the scope of this article.